On February 8th, AltsDb co-founder Jimmy Atkinson hosted Jay Hatfield, founder and CEO of InfraCap, for a comprehensive one-hour webinar tailored for financial advisors. The session, now available as an audio recording and on YouTube, delved into nuanced income investing strategies designed to navigate the complexities of the current macroeconomic landscape. Andy Hagans provided a brief introduction to the podcast version of the webinar.
The discussion was particularly timely given the volatile market conditions experienced in 2022, which saw significant downturns in both bond and publicly traded stock markets. In contrast, alternative investments generally demonstrated greater resilience, highlighting the importance of diversified strategies. The webinar aimed to equip financial professionals with actionable insights into constructing portfolios that can generate consistent income while mitigating risk.
The Enduring Appeal of Income Investing
Jay Hatfield articulated a compelling case for the sustained popularity of income investing, particularly for individuals nearing or in retirement. He emphasized that a robust income stream is foundational to a high-quality portfolio, offering a critical layer of financial security and psychological comfort, especially during periods of market uncertainty.
Hatfield recounted an anecdote involving a close friend who, after a previous advisor’s management, was surprised to learn his portfolio lacked substantial yield. By implementing a diversified strategy with a target yield of 4% to 5%, comprising both bonds and equities, the friend gained the financial confidence to retire. This personal narrative underscored the tangible impact of income generation on financial independence and lifestyle planning.
He further elaborated that for more conservative investors, a reliable income stream provides a vital buffer against market volatility. Even when market downturns are perceived negatively, the ability to reinvest income at lower prices and potentially higher yields offers a strategic advantage. Moreover, for those drawing income from their portfolios to cover expenses, the stability and growth of income streams, even amidst stock price fluctuations, provide crucial predictability. InfraCap itself is a significant holder of its own ETFs, reflecting a deep conviction in the efficacy of these income-focused strategies for a broad range of investors, not solely those in later life stages.
Economic Outlook and Income Generation in a Shifting Landscape
Hatfield provided a pointed assessment of the economic climate, noting that InfraCap had correctly anticipated the market’s challenges in 2022, particularly concerning technology stocks and speculative assets like cryptocurrency and meme stocks. This foresight stemmed from a clear understanding of the Federal Reserve’s monetary tightening policies.
"The rationale was very, very simple," Hatfield explained. "The Fed was tightening, they were reducing the money supply dramatically. In fact, I just talked about this on Fox Business this morning. They actually reduced the money supply by almost 20% last year, mostly through open market operations, not raising rates. So that’s why we were all feeling pain is the Fed was really sucking capital out of the capital markets driving both bond and stock prices down."
Looking ahead to the current year, InfraCap projected a top-decile target of 4,500 for the S&P 500. This bullish outlook is predicated on the belief that the most aggressive phase of monetary tightening is behind the economy. Hatfield highlighted the Fed’s use of reverse repurchase agreements (repos) as a significant mechanism for liquidity reduction, managing a $2.5 trillion reverse repo balance. This tool, often misunderstood, is key to absorbing excess liquidity from the financial system.
Despite anticipating two further rate hikes by the Fed, Hatfield did not foresee a significant recession. This optimism is bolstered by post-pandemic tailwinds, including persistent shortages in housing and automobiles, and a remarkably resilient labor market – a combination rarely seen during periods of Fed tightening.
The Nuances of Inflation and Monetary Policy
A central theme of the discussion was the Federal Reserve’s approach to inflation. Hatfield expressed a strong divergence of opinion, stating, "We believe the Feds completely out to lunch on inflation." He argued that the Fed’s reliance on indicators like the Phillips Curve, which links inflation to labor market dynamics, overlooks the primary drivers of significant inflation. According to Hatfield, high inflation is historically propelled by loose monetary policy, which fuels housing price inflation, and commodity price shocks, such as those seen in the energy sector.
He introduced InfraCap’s proprietary index, CPI-R (Consumer Price Index – Real), which calculates CPI using a methodology predating 1982. This index incorporates housing prices as a leading indicator for the shelter component of CPI, which the Bureau of Labor Statistics (BLS) often reports with a significant lag due to its reliance on owner’s equivalent rent estimates. CPI-R has indicated negative inflation over recent months, suggesting a deflationary trend, with an annualized rate exceeding 4%.
Hatfield elaborated on the potential for sticky reported inflation figures due to these reporting lags. While his real-time indicators suggest disinflation, the official CPI reports may continue to show elevated shelter costs, creating a disconnect. He noted that the Personal Consumption Expenditures (PCE) price index, which the Fed closely monitors, has a smaller weighting for housing, thus attenuating the impact of these reporting discrepancies. This analysis suggests that the Fed might pause its rate hikes sooner than anticipated, potentially by March or May, as PCE core inflation is forecast to fall below 3% by June.
Strategic Asset Allocation for Income and Growth
The webinar then transitioned to practical implementation, outlining strategies for constructing balanced portfolios that combine growth and income generation.
Fixed Income Alternatives
Hatfield presented a spectrum of fixed income alternatives, ranked by their correlation to U.S. Treasuries and the broader stock market.
- Treasuries: Currently offering decent yields, they remain a cornerstone for stability.
- Municipal Bonds: Providing tax advantages and slightly lower correlation to Treasuries.
- Corporate Bonds: Becoming increasingly attractive with yields around 5.4%.
- Preferred Stocks: These are highlighted as a particularly compelling opportunity, with average yields around 6%. Hatfield noted that by diversifying beyond the financials-heavy cap-weighted index, investors can access significantly higher yields, with InfraCap’s REIT preferred fund yielding over 7% and another fund approaching double digits. These instruments offer modest stock market risk, generally exhibiting around half the volatility of common equities.
- High-Yield Bonds: Currently offering attractive yields around 9%, with lower stock market correlation than preferreds.
- Senior Loans: Offering lower beta to the stock market and reduced interest rate risk, though with less attractive yields compared to other options.
Hatfield recommended a diversified approach, incorporating exposure to all these asset classes to build a robust bond portfolio, especially as Treasury yields have risen significantly from their lows.
Equity Income Strategies
On the equity side, the focus shifted to generating income through dividend-paying stocks:
- Utilities: While historically stable, they are currently viewed as overvalued based on their yields.
- REITs (Real Estate Investment Trusts): Considered undervalued due to excessive pessimism regarding cap rates and long-term real estate values.
- Telecom: Stocks like AT&T and Verizon offer attractive yields following recent price declines.
- MLPs (Master Limited Partnerships): Significantly improved from their past structures, now offering better capitalization, lower leverage, and well-covered dividends. InfraCap views them as a strong total return prospect beyond just income.
- High Dividend Yield Stocks: InfraCap’s ICAP fund, for example, offers yields well above the S&P 500’s 1.7%, aiming for the 4% to 5% income target.
A hypothetical 30/70 portfolio (30% fixed income, 70% equity) could yield approximately 4.67%, with conservative investors allocating more to fixed income potentially achieving yields of 6% to 7%. The key to achieving these yields, Hatfield stressed, is incorporating equity income sources that offer substantially more than the meager yields of broad market indices.
Deep Dive into Preferred Stocks and MLPs
Preferred Stocks
InfraCap strongly advocates for preferred stocks, especially for clients lacking exposure. The current market conditions present a unique opportunity: preferred stocks are trading at discounts to their par value, making them callable at par. This situation offers the potential for equity-like returns (price appreciation to par) while providing substantial dividends. InfraCap’s flagship preferred stock fund, PFFA, yields over 9%, with an SEC yield of 11.54%, indicating well-covered distributions. The fund’s structure, with 90% cumulative dividends and a focus on investment-grade issuers, mitigates default risk, which is historically comparable to investment-grade bonds.
Master Limited Partnerships (MLPs)
Hatfield addressed potential investor apprehension regarding MLPs, acknowledging past issues related to high leverage and growth-stock structures. He highlighted that modern MLPs have fundamentally reformed, featuring well-covered dividends, retained earnings for growth and share repurchases, and reduced leverage. These companies are now better capitalized and more resilient. InfraCap’s corporate MLP fund offers a K-1 free structure, providing capital gains treatment rather than recapture upon sale, and benefits from anticipated strong energy prices.
Addressing Investor Queries
The webinar concluded with a robust Q&A session, covering several key investor concerns:
- Yield Curve Outlook: Hatfield anticipates the yield curve will likely remain inverted for the next two years due to the Fed’s rearview-mirror approach to policy. However, he foresees long-term rates settling around 3% to 3.25% driven by demographic shifts (the retirement boom) and modest global economic growth.
- Financial Sector View: InfraCap is positive on financials, particularly regional banks, citing exploding net interest margins due to the yield curve and an overestimation of loan write-offs by the market. They believe the risk of mass unemployment, a key driver of credit defaults, is not supported by current data.
- Blended Growth and Income Portfolios: For younger investors with longer time horizons, Hatfield suggested increasing allocations to higher-yielding assets like high-yield bonds and preferred stocks, potentially reducing or eliminating Treasury exposure. The equity portion could still include dividend-paying stocks, REITs, and MLPs, while potentially avoiding overvalued sectors like utilities and telecom.
- Yield Metrics: The distinction between SEC yield (an SEC-mandated estimate based on portfolio income and expenses) and distribution yield (actual payout) was clarified. Hatfield emphasized the importance of an SEC yield that adequately covers the distribution to avoid return of capital and preserve NAV.
- Public vs. Private Market Valuations: Hatfield acknowledged that public markets often trade at discounts compared to private markets, which can be an inefficiency or a sign of more realistic valuation. He noted that assets like preferred stocks, currently trading at a discount, represent an opportunity.
- Short-Term Treasuries and CDs vs. Alternatives: While 1-2 year Treasuries and 5% CDs offer safety and yield, Hatfield argued that they miss the opportunity for higher, sustained returns and potential capital appreciation offered by assets like preferred stocks, which can yield 7-9% or more. He cautioned that short-term rates are likely to decline, making rolling these instruments less attractive over time.
The webinar concluded with an invitation for financial advisors to visit infracapfunds.com to learn more and access the presentation deck. The recording is slated for release the following day, providing a valuable resource for professionals seeking to enhance their income investing strategies.
